Corporate Profits, Economic Growth, and Equity Valuation

Scott Grannis asks:

Corporate profits are fantastic—what's wrong with equity prices?

As I've discussed numerous times (an example is Equity Valuation Matters), over the long run, earnings matter for equities and those earnings are very closely tied to underlying economic activity. However, over the short-run, earnings (and equity prices) may dislocate from the underlying economy due to a number of factors. In the current market where earnings have dislocated in a positive direction, some reasons may include cost cutting, accounting that allows banks to smooth write downs, low taxes, cheap financing, and a lack of competition for corporations (i.e. the struggles we've seen within the small business sector).

This is another way of saying that all earnings are not created equal. If earnings could in fact consistently grow faster than the underlying economy, then earnings would eventually be larger than the economy itself (a mathematical impossibility). A warning sign is that in the most recent data, as shown in Scott's chart, corporate earnings as a percent of GDP are above 10%, 4% above its 50+ year average.

While this 10% level is unprecedented over the past 50+ years, dispersion between earnings and/or equity performance and nominal economic growth is not. However, in the long-run (sometimes a very long-run), the relationship tends to be very tight. The chart below shows this connection in a chart normalizing data going back to 1951 (the BEA has data going back three more years to 1948, but the relationship is the same).

As for equities being cheap, I actually happen to believe there is in fact a lot of value out there, but I personally wouldn't call the broader market cheap with all the tough issues that need to be addressed. In addition (ignoring whether earnings are / are not sustainable), it matters when you start looking. As Scott outlined, over the last 10 or 20 years, earnings have grown faster than equity valuations. However, over the last 60 years (i.e. the chart above), equities are actually outperforming (i.e. P/E's have expanded).

Source: BEA, Yahoo Finance

P/E Excluding Cash and Short-Term Investments

The below shows the Price / Earnings ratio for all components of the DJIA excluding financials (don't have a clue as to whether their earnings are legitimate, let alone sustainable), as well as the Price / Earnings ratio excluding cash and short-term investments. All data was pulled from the latest figures as presented within their last quarters financial statements.



I understand the counter to some of those insanely cheap looking earnings:

Not sustainable

Technology no longer feasible (i.e. Apple will steal the entire market)

Value trap

But some of these companies look CHEAP.

Source: Yahoo Finance

Taking a Look at the Cash Hoarders

The Huffington Post details the top 11 cash hoarders.

Instead of building plants or hiring workers, corporate America is clinging to its cash.Companies are sitting on $1.93 trillion in cash and liquid assets, the highest level since 1959, the Wall Street Journal reports.

With high unemployment and families still limiting their spending, corporate America is backing away from expansion. But with interest rates on the heaps of cash so low, that $1.3 trillion might as well be stuffed in a mattress.

Below is a chart of the cash levels for 10 of the 11 (I excluded GM as they don't have 12 month's of positive earnings), the earnings yield of each company (defined as the inverse of the P/E ratio), and the adjusted earnings yield that backs out the cash from the corporation's market value to determine the earnings power of the company less cash (normally you would have to account some earnings to the cash, but in the current environment, that is minimal).



Note that all cash data is directly from Huffington Post and Google Finance (I did not go through financials) and is presented without analysis or determination as to whether any of the figures should be adjusted for any reason. That said, if the cash is returned to investors via dividend or buyback OR the cash is put to good use, corporations appear cheaper than they might first appear.

MSFT vs. AAPL Earnings

Ahead of this Thursdays Microsoft earnings (consensus is at 55 cents / share or ~$4.76 billion), a comparison of Microsoft's quarterly earnings (in billions) to Apple's.



I'll leave the fundamental analysis for those smarter than me, but as can be seen:

1) Microsoft still out-earns Apple
2) That earnings gap is decreasing rapidly as Apple's earnings growth have been nothing short of astronomical
3) Microsoft earnings have been nothing to sneeze at, up more than 13% annualized over the past four years (June '10 vs June '06) despite the economic slowdown
4) You can buy a dollar of Microsoft earnings for a bit more than $12 or about half the price of Apple's (this does not make Apple rich; it just means Apple better keep growing at a fast clip)

Source: Daily Finance

Are Corporate Earnings Sustainable?

Last week, EconomPic showed the historically relationship between the treasury yield and nominal GDP growth. Below, we compare corporate earnings growth to the treasury yield over that same ten year window.

What we see is that earnings on a cyclically adjusted basis (smoothed per Shiller) have been growing faster than the broader economy for the past ten years.



My thoughts (as shared last month):

The important question is how these earnings have come about. We all know that recent earnings have ratcheted higher due to reduced costs (job cuts, lack of investment, cheap financing) rather than top line growth. In other words, executives for public firms have caught up with the "buy, strip, and flip" nature of private investors.

In addition, simple math proves that earnings cannot grow faster than nominal growth over the long term, as that would imply earnings at some point become larger than the economy as a whole (not possible as earnings are part of the economy).

In summary... expect earnings to be under pressure in the not too distant future unless there is surprise outsized rebound in the economy.

Source: Irrational Exuberance

More on Equity Earnings Yield

EconomPic has detailed the (what appears to be) relative attractiveness of the earnings yield of the S&P 500 on multiple occasions the past few months (here, here, and here are a few examples). Below we make another comparison... the earnings yield of the S&P 500 (in this case using Shiller's cyclical adjusted earnings) to the BBB corporate bond yield going back 35 years.

What the chart below shows is that the yield of S&P 500 has now surpassed that of the BBB rated corporate bond market (i.e. the lowest rated investment grade bonds) for the first time since the early 1980's.



Bull Scenario

Forecasts are for earnings to continue to grow.



Bear Scenario

Forecasts are just forecasts; a likely scenario is that forecasts are too rosy and earnings will reverse course (though this was accounted for in part within the first chart through the use of the CAPE [cyclically adjusted earnings], which uses a 10 year average of earnings). But it is possible that earnings over this entire 10 year period have been amplified by leverage, low interest rates, and a lack of reinvestment as production was pushed offshore. John Hussman (hat tip Credit Writedowns) provided the background for this a month back:

Current forward operating earnings estimates assume profit margins for the S&P 500 companies that are nearly 50% above their long-term historical norms. While we did observe such profit margins for a brief shining moment in 2007, profit margins are extraordinarily cyclical. Investors will walk themselves over a cliff if they price stocks as if profit margins, going forward, will be dramatically and sustainably higher than U.S. companies achieved in all of market history.

And this all may just prove that BBB corporate bonds are simply rich. According the Barclays Capital BBB corporate index, BBB corporate bond yield are just 4.4%... an all-time (since the index was tracked in 1988) low.

Source: S&P / Irrational Exuberance

Earnings Season has Been Strong

Bespoke Investment Group (hat tip Abnormal Returns):

S&P 500 stocks have been beating earnings estimates at a much higher rate. Through yesterday, 78.8% of S&P 500 companies had beaten expectations. Interestingly, the high beat rate for the S&P 500 hasn't translated into better stock performance.

Source: S&P

On the Relationship Between Earnings and Yield

Trader's Narrative (hat tip Abnormal Returns) has an interesting piece from Wayne Waley (CTA) about the relationship between S&P earnings and interest rates. His conclusion following an analysis of data since 1970:

During periods of extremely low interest rates, stocks can reasonably be expected to sell in a P/E range somewhat higher than the historic 10-20 range. It is difficult for me to envision the P/E’s going to single digits during this bear market cycle (as has been the case in many previous inflationary bear markets) - unless the single digit P/E’s come far down the road when interest rates are much higher (above 5%).

Based on this conclusion, he believes stocks are trading at a low end of the range. There is an obvious flaw in his analysis, one that even Wayne points out in his devil's advocate 'argument that a bear would make':

If you go back to the 1950s or 1930’s you can find cases where the above interest rate/earnings relationship fails.

Actually, if you go to any point before 1970 (going back to 1910)... there were no other extended periods with a strong relationship between the two.

Earnings vs. Rates (in this case the 10 year interest rate rather than the blend)

Ten Year Rolling Correlation Between Earnings Yield and Ten Year Treasury Rates

Two questions I personally want answered:

1. What happened in 1970 that would have caused the relationship between the two (initial thoughts include demographics [i.e. baby boomers], the growth of retail investing, and the increased debt added throughout the financial system)?
2. Whatever the answer to #1, will that/those relationship(s) remain in an economy that faces deleveraging and a rebalancing within the global economy?
   

Source: Irrational Exuberance

Earnings Jump... Cause for Economic Concern?

The Good: Earnings are up.

As Doug Kass detailed Wednesday morning (with what appears to be some great timing), this may be reason to believe that stocks have hit bottom for the year:

Trading at around 11 times earnings, stocks are fairly inexpensive, says Kass. He notes stocks generally trade at around 15 times future earnings, and even higher in periods of tame inflation and low interest rates, as we're currently experiencing.

Rather than P/E ratio, below is E/P (i.e. earnings yield) of the S&P 500 going back 100 years (note that earnings yield appears to be at a 20 year high).

The Bad: Earnings are up.

The important question is how these earnings have come about. We all know that recent earnings have ratcheted higher due to reduced costs (job cuts, lack of investment, cheap financing) rather than top line growth. In other words, executives for public firms have caught up with the "buy, strip, and flip" nature of private investors. Yves Smith and Rob Parenteau detail the impact on the "actual" economy:

The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies.

And a similar story from the Chicago Tribune, Corporate Spending Good for Economy, but Bad for Profits, with a focus on the analyst community.

But even optimistic analysts, those who have ruled out a double-dip recession and see growth continuing at a modest pace, are wary. Some are raising concerns that companies will fall short on the profits investors are expecting, and they think the recent sell-off in the market comes from investors afraid to wait.

The cautious stance is not merely a symptom of global economic worries. Rather, some analysts contend that companies now must spend more money if they are to increase profits at levels that will satisfy investors. Yet, if they are spending more, and a weak economy stifles sales, that spending could backfire, leaving companies with disappointing profits and disappointed investors.

Source: S&P / Irrational Exuberance

Corporate Earnings: Mixed, but Broadly Upgraded...

In this week's edition of EconomPic Q&A, a new reader asked:

I'm looking for a report on sector earnings. I want to see what percentage of companies have beat/missed earnings in each sector. Any ideas??

Standard & Poor's has a ton of information on their site, including detailed breakout of all sector components of the S&P 500's earnings estimates. Below is not exactly the answer to the question (percent beat / missed, which is broadly ~75-80% "beats"), but rather how much estimates have changed since earnings season began a few weeks back.



Source: S&P

Q2 Earnings: Front and Center

The AP reports:

Investors, whose optimism was recently shaken by surprisingly weak economic data, are now hoping companies can provide some clues about a recovery.

Wall Street's focus this week shifts from economic reports to corporate earnings announcements and forecasts for the rest of the year. After investors were rattled last week by the latest consumer and employment data, there is growing uncertainty in the market about how strong the second half of the year will be.

"From this point on, we're going to start talking a lot more about how the second quarter was and that is going to be the biggest market driver," said Scott Colyer, chief executive of Advisors Asset Management in Monument, Colo. "What we want to see is continued recovery."

Taking a look at reported earnings of the S&P 500 (both with and without financials) we see the huge drop off in earnings after Lehman failed last September, affecting ALL corporations whether they were involved in finance or not as the economy stood still.



Now...

"This economy is starting to stabilize," said Burt White, chief investment officer at LPL Financial in Boston. "The market is looking for companies to do the same thing."

Source: S&P

Inequality and Entitlement

In Felix Salmon's post The Plight of the Overpaid, he details Gabriel Sherman's New York Magazine article The Wail of the 1%, which takes on those bankers that feel they still deserve to be paid in excess:

As Sherman says, bankers are the last Americans to Get It: they don’t think that the excesses of Wall Street were responsible for wealth destruction rather than wealth creation, and they still think that a degree from Wharton is, in and of itself, a Good Thing. One financier essentially tells Sherman that the going rate for any job which involves being woken up in the middle of the night should be roughly $2 million a year — which is not the kind of attitude guaranteed to make you friends among, say, the farming community.

Most people outside Wall Street have come to the conclusion that excess pay was a direct cause of the current meltdown, but the highly-paid symbolic analysts at our biggest investment banks somehow have a massive blind spot when it comes to that fact.

The entitlement is striking, but is somewhat explained by the reality that the third quartile American earns 2x more than the first quartile (i.e. what has been reality becomes ingrained that it should be reality).



Yet 'Wall Street' vs. 'Main Street' is far from the only source of inequality that remains. In fact, according to the BLS the median Asian man earns more than 50% more than the median Hispanic man (both of which earn more than the woman of either race).



While I absolutely believe in capitalism, getting a brand name education, a finance job, and being the "right race" should not in itself equate to substantially more income than someone who just didn't have the same opportunity (this coming from someone who went to an Ivy League business school, works in finance, and is white so take that with a grain of salt). While I do not believe in the redistribution of wealth for redistribution of wealth's sake, if taxes are used to create the same opportunities for all and shifts income to jobs that truly add value to our economy, I'm all for it...

Source: BLS

FDIC Insured Institutions: System Wide Loss

Interest Rate Roundup reports:

Every quarter, the FDIC releases a document called the Quarterly Banking Profile. It provides a wealth of data about banking industry losses, loan performance, failed banks, and more. The latest report (PDF Link) just hit the tape, and here are some of the details:

The banking industry as a whole lost $26.2 billion. That was a large swing from the year-ago profit of $575 million that the industry generated. It was also the first time since Q4 1990 that U.S. banks, in the aggregate, lost money.

And that -$26.5 billion would have been 50% worse had it not been for the $13.6 billion credit for income taxes (coming from those losses). If they can ever take them is another story.

includes Source: FDIC

Earnings Roundup

Source: The Big Picture

Goldman Earnings Hit, Pay Down to a Puny $395,000 per Employee

Marketwatch (bold mine):

Goldman Sachs paid its average employee sharply less in fiscal 2008 than in 2007 amid one of Wall Street's most dismal years ever. Speaking to reporters on a conference call Tuesday, Chief Financial officer David Viniar said, "compensation will be significantly lower this year (FY 2008)." Earlier, Goldman reported its first ever loss as a public company. When it reported those results, it also reported that its average compensation per employee in 2008 fell to about $395,000, down sharply from more than $660,000 in fiscal 2007. And, the firm said it set aside $10.93 billion for total compensation and benefits in 2008, down 46% from $20.19 billion a year ago.

Why Does Anyone Rely on Estimates?

MarketWatch reported:

Freddie's third-quarter loss came to $19.44 a share, far larger than the $1.2 billion, or $2.07 a share it lost in the year-earlier period. Much of that loss came from a $14 billion non-cash charge to write down the value of tax credits it had built up. Doubts about the ability of the company to make money in the future and utilize those tax credits caused that charge.

With all the troubles in the market, analysts surely saw this coming right?



As James Surowiecki points out at the New Yorker:

They were “looking for a loss of 89 cents per share.” So they only missed it by that much.

Remember this the next time you hear equities are cheap based on estimated future earnings.

"Rich Man's Burden"

Interesting Op-Ed in the NY Times yesterday by Dalton Conley, titled "Rich Man's Burden":

At one time we worked hard so that someday we (or our children) wouldn’t have to. Today, the more we earn, the more we work, since the opportunity cost of not working is all the greater (and since the higher we go, the more relatively deprived we feel).

In other words, when we get a raise, instead of using that hard-won money to buy “the good life,” we feel even more pressure to work since the shadow costs of not working are all the greater.

He continues:

But it turns out that the growing disparity is really between the middle and the top. If we divided the American population in half, we would find that those in the lower half have been pretty stable over the last few decades in terms of their incomes relative to one another. However, the top half has been stretching out like taffy. In fact, as we move up the ladder the rungs get spaced farther and farther apart.

The result of this high and rising inequality is what I call an “economic red shift.” Like the shift in the light spectrum caused by the galaxies rushing away, those Americans who are in the top half of the income distribution experience a sensation that, while they may be pulling away from the bottom half, they are also being left further and further behind by those just above them.

GM: A Picture is Worth a Thousand Words...

Source: Infectious Greed

Loss of 6.7 Million StarBUCKS

WallStreet Fighter Reports:

For the first time since the company went public in 1992, Starbucks has announced a quarterly net loss.

Last year at this time, Starbucks announced a quarterly profit of $158.3 million, but now it's a $6.7 million quarterly loss. Oh how the mighty have fallen in these dark recession days.

Is there any non-essential luxury item consistently being purchased in this era? Now that porn is out, maybe cigarettes?

In spite of this news, Starbucks shares traded 5% hirer today because many investors are happy that many store locations are closing. Even their own investors think they have too many stores. So we're all in agreement now - that Starbucks across the street from another Starbucks plan was a bad idea, right?

Better get out and use that FAKE free drink coupon before anything worse happens to the coffee kings. That is, as long as your local 'Bucks is still alive and brewin'.